Understanding corporate finance: derivative contracts: futures: example of a commodity future
A gas future
Datchlow plc, a UK manufacturing company, is a major user of natural gas in its factories. It has a contract with a gas supplier under which it pays monthly for the gas it uses, on the last day of each month, at the market price on that day.
At the end of October 2008, the company anticipates that natural gas prices may rise in November. It decides to hedge its position by buying 1-month natural gas futures on the London Petroleum Exchange.
On 1 November, it buys five contracts or ‘lots’ for the month of November. Each lot is for the notional delivery of 1,000 therms of natural gas on each of the 30 days of the contract period, so the contracts are over 150,000 (1,000 x 30 x 5) therms of natural gas. On 1 November 2008, natural gas futures are trading at £11.90 per therm, so the contracts will cost Datchlow plc £1,785,000 (£11.90 x 150,000).
On 28 November 2008, Datchlow plc decides to close out the position by selling five natural gas futures contracts. (The company could opt to take delivery of natural gas, but has no reason to do so - it is already locked into a contract for the supply of gas.) At that date, the contracts are trading at £12.15 per therm, so the company’s position is worth
£12.15 x 150,000 = £1,822,500.
The company has made a profit of £1,822,500 - £1,785,000 = £37,500.
This profit will wholly or partly offset the additional amount the company has to pay on its November gas bill.
Datchlow plc does not actually have to pay out £1,785,000 when it buys the contracts. Instead, it has to put up margin, equal to the maximum amount which the clearing house feels it might lose on the contract in one day (see CFM13070).
Suppose that on 1 November the company puts up initial margin of £5,000 per lot, or £250,000. At the end of the day’s trading, the position is marked-to-market. Suppose that the price of natural gas has fallen by 2p per therm. The company has made a loss on the day’s trading of £3,000 (150,000 therms x 2p). The minimum amount of margin which the company must maintain is increased by £3,000 to £253,000. It must pay the additional £3,000, or the clearing house will automatically close out its position.
Further suppose that on 2 November the price of natural gas rises by 3p per therm. Datchlow plc therefore makes a profit on the day’s trading of £4,500 (150,000 x 3p).
The minimum amount of margin it must maintain is reduced by £4,500 to £248,500.
The company is thus able to realise its profits or losses on a daily basis.